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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » Shouldn’t EPF invest in stock market?

Shouldn’t EPF invest in stock market?

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1Shouldn’t EPF invest in stock market? Empty Shouldn’t EPF invest in stock market? Sun Oct 21, 2012 4:48 am

sriranga

sriranga
Co-Admin
By R M B Senanayake

The Trade Unions have gone to the Supreme Court for a direction that the EPF which is the fund of employees should not invest in the Stock Market except in blue chip companies. They also want the banks to be excluded from these permitted blue chip companies.

Stock Markets are risky
Certainly stock markets are risky and when there is a tumble in the market many investors particularly large investors will be holding shares whose values have fallen. Financial markets do not operate in the same way as markets for goods and services. When the price of a television set or an electric cooker goes up the demand for such good generally falls. This is the law of demand for goods and services. But this rule does not apply in the case of financial markets like the stock market.

Why the difference? It is because in the case of goods and services they are bought for a specific purpose in mind. They are bought for the service or satisfaction they provide. The desire to buy them may be driven by fashion or to enhance the individual’s status as in the case of a demand for a sports utility vehicle. These satisfactions are inherent in the goods themselves. Such goods may be purchased as a means to an end but the nature of the means is still important.

But consider financial assets. They are desired for one reason only – their ability to enhance or preserve the buyer’s wealth. So while one would buy more of a good when its price falls and less when its price rises, the stock market follows a different pattern. When one investor tells his friends how he made money in the stock market (people like to boast about their profits in the market often not admitting the losses they make) the friend also enters the market. So we have what is called the herd instinct where people buy stocks that keep rising in price instead of buying stocks which are low in price.

So rising stock market prices induce more and more people to come into the market. In a way it is like a pyramid scheme. Those who came in first and bought the share before it went up too much will benefit most when they sell out and realize their profits. Those who hold on to the losing share, may suddenly find that the price movement has reversed and since many investors are averse to making a loss they hold their shares and get alarmed when the shares keep falling. So trading volume tends to dry up as new investors do not enter the market and existing investors want neither to realize losses nor to hunt for bargains.

This is the situation today in the stock market which has been falling this week after a temporary rally which was boosted by hype about the new Chairman of the SEC and the so-called relaxation of credit which made no real change to the Rules. But even a more market friendly Chairman of the SEC cannot change the fundamentals. Asset prices like the prices of other goods and services are set by markets. But the markets for assets operate quite differently from the market for goods and services.

While the small retail investor can sell out and cut his losses, it is not easy for the Funds to do so because their holdings of a particular share are large. It is difficult to sell large quantities in a small market. This is the reason why many foreign funds do not come into our market. But when they do come in they do not dump the shares merely because the market has fallen.

They are long -term investors who select stocks for their long term growth potential. But they hold such stocks for the long term and do not sell out. The EPF has no option but to do the same. What goes down will come up again as long as the economy grows. Although the growth rate has fallen yet it is still a positive 6.5% unlike the growth in developed countries which have fallen heavily and even entered negative territory in the Euro Zone.

Principal Agency Problem
Should the discretionary power of a Fund Manager be restricted as proposed by the Trade Unions? Of course not. The reason is that investment is a skill which has to be acquired through market experience. The problem is what economists refer to as the agency problem. The EPF contributors are the principals the owners of the Fund. But there is the general problem of principal and agent. Those absentee owners of estate know what the problem of agency is. The agent who is the manager of his estate does not have the same objectives as the principal. The principal must induce the agent in this case the Manager to act in his interest rather than the agent’s interest. This requires the principal to put in place incentives which will make the agent to act in the principal’s interest. The principal does not have the full information that the agent who is on the spot has. So the principal has a problem of monitoring the agent’s behavior. This prevents the principal from successfully telling the agent what to do for he cannot fully observe what is happening. In any event he would usually want the agent’s behavior to depend on the circumstances that only the agent can observe.

The contributors to the EPF are the principal but they cannot monitor the behavior of the EPF Fund Managers. So any interference with the investment decisions of the Fund Manager is not in the interest of the principal in the long run. True there are allegations and they must be probed. But to deprive the Fund Manager of his discretion is not in the interest of the principal. What should probably be done is for the Fund stakeholders to meet with the Fund Managers at least once a year when the accounts of the Fund should be tabled for approval.

If the EPF is allowed to invest only in a few blue chip companies this will cause even more money to flow into a few stocks popular with foreigners and drive them even higher and foreigners who value stocks based on fundamentals will fight shy of buying these stocks. There will be even less foreign capital inflows to the stock market. Let the EPF manage the Fund but monitor their investments. No fee should be paid to the Fund Manager- the Central Bank if it has made losses during the year. In UK too this problem of losses caused by pension funds investing in the stock market has been under discussion recently. The solution proposed is to insure the contributions so that no employee will lose what he and his employer have contributed. Some sort of insurance or guarantee is what is required.
http://www.nation.lk/edition/opinion/item/11651-shouldn%E2%80%99t-epf-invest-in-stock-market?.html

http://sharemarket-srilanka.blogspot.co.uk/

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